Qualified Small Business Stock (QSBS): A Strategic Tax Planning Tool

Speaker 1 – 00:00
Welcome to EWA’s FinLit podcast. EWA is a fee only RIA based out of Pittsburgh, Pennsylvania. We hope all listeners
of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And
we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your
family and also save time.
Speaker 2 – 00:27
Today’s episode we’re talking about a very exciting topic, qsbs. And this is just a way that we’ve seen small business
owners save a enormous amount of taxes when they sell their business. But some simple, some complex rules that
we’re going to simplify today for you, give you some real life examples of how this can be done. So first of all James,
what does QSBS stand for? Just give us a general breakdown of it.
Speaker 3 – 00:54
Yeah, it stands for Qualified Small Business stocks. It’s section 1202 in the tax code. Long and short of it is if you are
a qualifying business, which we’ll talk about and you sell your business, a portion of the sale can be tax free, which
obviously could be pretty huge.
Speaker 2 – 01:13
Yep. So this is capped at 10x your basis. Right. Or $10 million. So just for an example, if you have a business that
you have a basis of 10 million now you’re selling it for 20 million and you meet all the requirements, you would be
able to avoid the federal capital gains tax on that $10 million gain which would be if you’re in the highest tax bracket
would be, you know, a 2.38 million dollar tax savings. Just as a simplicity and to under.
Speaker 3 – 01:43
Just to make sure people understand that your basis, you’re not going to pay tax on your basis regardless if you
weren’t qsbs, it’s just the gain that you on so you know, 10 million of the gain essentially you could avoid.
Speaker 2 – 01:54
Absolutely. So let’s go through just first like what are the conditions that need to be met? And so the first condition is
we’ll just go back and forth here Jameson. So the first is you have to be a C corporation. And so a C corporation
does come with some downsides. There’s double taxation. When looking at, you know, let’s say someone’s profiting
over a million dollars and they’re an S Corp structure right now and they, if you flip to a C corp, generally speaking
lead to the sale, you’re going to pay an effective tax rate maybe 2 to 5% higher than you’re already paying. So you are
going to pay a.
Speaker 1 – 02:29
Little bit of a higher tax.
Speaker 2 – 02:32
So let’s say you’re paying 20 to $50,000 a year higher tax for five years. Let’s just say 250 in exchange. If you save
that $2.3 million, obviously you know, that’s still a $2 million plus savings of taxes. But you need to be aware of that.
You have to be in C Corp. C Corp. With the rules of double taxation typically do come with higher tax rates as you’re
going. If you’re cash flowing out of the business now if you’re retaining earnings, keeping money in the business, it
could be a little bit lower, but it’s going to get double tax later and catch up on the back end. So if you don’t plan on
selling, you know, generally speaking you should stay as an S Corp, you know, maybe an llc partnership because of
the rules.
Speaker 2 – 03:12
If you specifically are looking as a small business owner to sell, then the C Corp for the purposes of the USPS could
make a lot of sense. So James, with that being said, what’s rule number two?
Speaker 3 – 03:24
The size of the small business. So companies gross assets must be $50 million or less at the time of the stock
issuance. And then so basically let’s say you have an S Corp. You’re thinking you’re going to sell in five years, you flip
to a C Corp. At the time when the C Corp stock issued, the total assets have to be under 50 million. And then that
would be, that would qualify you for QSPs.
Speaker 2 – 03:51
All right, so number three, active business requirement. You have to have at least 80% of the company’s assets must
be in a qualified trade or business. So some industries do not apply. Professional services like law, accounting,
unfortunately financial services, we can’t do this. Healthcare, banking, insurance, financing and investing businesses
and hotels, restaurants and similar businesses. So those are the ones that you can’t, Examples of ones that could for
example would be like H Vac Company.
Speaker 3 – 04:17
Tech is, this is huge in tech.
Speaker 2 – 04:18
Tech is massive. We’ve had lots of clients in tech startups that have done this and we’ve seen some companies have
successfully, you know, hit and use this to avoid. We’re talking millions and millions of taxes. Okay so number four,
so the way.
Speaker 3 – 04:35
That the original stock issued, the stock must be purchased directly from the company, not from another
shareholder. So, so let’s just example here. Let’s say Matt and I are 50 partners in a business. And let’s say Matt
100% owns the business and I’m going to buy 50%. The way the transaction would have to occur, I can’t buy it
directly from Matt would have to sell his 50% back to the business and then I purchase the shares from the
business. So you can’t buy them from an individual, it has to be from the corporation.
Speaker 2 – 05:09
Yeah, very important to note. And so typically this is for like founders, maybe the first 10 or 20 team members that
you know were attracted on take a high risk in like a tech startup that got offered equity up front right from the get
go. So holding period requirement, the shareholder must have the stock for at least five years before selling to
qualify for the tax benefit. So that could mean if you’re a Business 100 business owner, you’re converting from an S
to a C corp. Doing so five years before the sale would guarantee eligibility, assuming you meet these other four
requirements.
Speaker 2 – 05:46
And then, or you know, let’s say you’re part of a tech company and you go public or you get acquired, you’re, you’ve
been, you know, holding the stock for two years, you would want to continue to hold that for another three years after
to meet that total five year requirement. So okay, so now there’s some, the laws around this have changed and so
there’s been some adjustments in dates as far as exclusion amounts. So James, do you want to walk us through
those and what that means?
Speaker 3 – 06:16
Yeah, so you get 100% exclusion if the stock was acquired after September 27, 2010. These are interestingly like
specific dates. It’s kind of funny. 75% exclusion if the stock was acquired between February 18, 2019 to September
27, 2010. 50% exclusion if the stock was acquired before February 18, 2009. So basically long and short of it,
anything after September 27, 2010, you’ll get 100% exclusion on those either 10 extra basis or the 10 million or cath.
Speaker 2 – 06:54
At 10 million, whichever one. Yeah.
Speaker 3 – 06:56
And I think one thing it’s important to know is these are stackable. So what that means is let’s say you own 100% of
a business, you’re married, you have a spouse, you have two kids, you could theoretically take a portion of the stock,
have your wife or spouse own it, you could take the other portion for your kids, have a trust own it for the beneficiary,
the kids would beneficiary. That’s four $10 million exemptions that you could use.
Speaker 2 – 07:28
So say that four again, that you, the business owner, your spouse, trust, two different trusts. Okay.
Speaker 3 – 07:36
Yeah. Two trusts.
Speaker 2 – 07:37
So in that example, let’s say you have a $10 million basis in a company and you’re selling the company for 50 million
before the sale. Five years before we convert from an S Corp to a C Corp. You retain 25% ownership, you make your
wife 25% ownership, you make the trust for child one, 25% ownership. And trust number two for child number two,
25% ownership, you sell the company for $50 million. We’re now avoiding 23.8% federal tax on all $40 million of
gains. So if you’re that example, $40 million gain, a wife and two kids with the two trusts were paying zero taxes.
Plus you want to have that money in a trust also because then you’re going to avoid estate taxes in the future on
that. You’re going to utilize the majority of your lifetime exemption.
Speaker 2 – 08:28
But typically after that sale hits and you can reinvest that money in, you know, publicly traded stocks or other
vehicles inside of the trust.
Speaker 3 – 08:36
And then from a state standpoint, there are a couple of states that exclude this. So all that means is you can still get
the federal tax savings, but you may still have to pay state taxes on the sale, which is obviously far less than what
the federal taxes are.
Speaker 2 – 08:51
Absolutely, absolutely. So you just as an example, like Pennsylvania is one, California, Mississippi, Alabama, if you’re
a business owner in those states, you can absolutely still do QS BS and avoid that big 23.8% federal tax, but you’re
still going to pay state taxes on the gain. So in Pennsylvania you still pay the 3.07% on the capital gain. Doesn’t mean
you can’t do QSBs, it just means you have to pay the state taxes still. Perfect. Well, I think that’s, that’s it for the high
level. You know, this is very case by case, it’s a very case by case structure. I think this is a no brainer at certain
levels.
Speaker 2 – 09:36
If your goals are legacy for the kids, you’re selling your business and you know, being tax efficient is important and
you have, you know, you’re on the back end if you’re a 25 year old and you have a 25 year Runway, but you’re not
planning on selling the business. You know, probably a C Corp operating for 25 years doesn’t make sense. There’s a
break even there. So this is a no brainer for some clients that want to sell. But for some clients that are unsure or
have a huge Runway, I would steer clear of it. You know, but that’s a case by case analysis that we can do. For those
interested in reviewing this.
Speaker 3 – 10:13
Yeah, let’s give these two like real examples. So one, let’s say you have a tech startup, founder starts a C Corp
company or converts the S Corp to C Corp. Issues himself a million shares. Five years later the company’s acquired
50 million. The founders shares are now worth 20 million. If the shares qualify for QSBS, the first 10 million are tax
free. Remaining 10 million could be capital gains tax. Or like Matt said, if there’s a $10 million basis in there, you
could avoid the first 10 million, avoid the second 10 million of tax as well. Another example, if you’re an investor in a
company, let’s say you invest half a million bucks in a qualifying startup that’s going for QSBS. After five years, the
shares are now worth five and a half million. In that scenario, the entire five million of gain.
Speaker 3 – 11:02
Again, your 500,000 year basis is tax free. So it can work, you know, if you’re investing or if you’re the business
owner.
Speaker 2 – 11:08
Absolutely. Okay. Any other closing thoughts? I mean I think this is a. Yeah, yeah.
Speaker 3 – 11:14
I would just say it’s becoming more and more relevant now because, and there’s a huge. What is it, 85% of wealth in
America is over with people over the age of 65. Some statistic like that.
Speaker 2 – 11:27
A lot of people are going to be exiting their businesses and looking to sell.
Speaker 3 – 11:30
Yeah, a lot of, you know, baby boomer generation business owners that will be, you know, going to retire that this
could be really applicable for.
Speaker 2 – 11:38
Awesome. Well, thanks for joining us and look forward to catching everyone next week. Feel free to reach out with
any questions on usbs.
Speaker 1 – 11:44
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